Over the last couple of week’s, I have written extensively about the breakout of the market above the downtrend resistance line that traced back to the 2015 highs. To wit:
“With the breakout of the market yesterday, and given that ‘short-term buy signals’ are in place I began adding exposure back into portfolios. This is probably the most difficult ‘buy’ I can ever remember making.”
I also stated that it was probably a trap and that I will be stopped out in fairly short order. But that is the risk of managing money.
It was only a matter of time before the extreme short-term extension of the market begins to correct. Like stretching a rubber band to its limits, it must be relaxed before it is stretched again. The question is whether this is simply a “relaxation of the extension” OR is this a resumption of the ongoing topping and correction process?
Let’s take a look at a few charts to try and derive some clues as to what actions we should be taking next.
First of all, it is worth noting that despite all of the recent excitement of the markets advance, it remains extremely confined in a sideways trading range. This can either be good or bad news.
The Good: Sideways consolidations during bullishly biased markets provides the ability to work off excesses built up during the previous advance to provide the “fuel” necessary for the next leg higher.
The Bad: However, sideways consolidations can also mark the end of the previous bullish advance and the beginning of a bearish decline.
How do we know the difference? Normally, fundamentals tell the story. When earnings are still rising, market consolidations tend to resume to the upside. However, declining earnings have historically marked market topping processes much as we see today.
Back to our first chart above, I have denoted the previous declining market trend and an adjusted downward trend line to account for the most recent peak. Both of these downward trending price lines will now act as resistance to the next attempt by the market to rally higher.
With the markets still extremely overbought from the previous advance, the easiest path for prices currently is lower. The clearest support for the markets short-term is where the 50 and 200-day moving averages are crossing. I currently have my stop losses set just below this level as a violation of this support leaves the markets vulnerable to a retest of February lows.
On a short-term (daily) basis, the current correction is still within the confines of a simple “profit-taking” process and does not immediately suggests a reversal of previous actions. As shown in the chart below, support current resides at 2040 with the 50-day moving average now trading above the 200-day.
It is worth noting the similarity (yellow highlights) between the current rally and peak versus the rally and peak during the October through December advance.
The good news is that the advance-decline line, currently remains a positive backdrop to the recent price action. My friend and colleague, Dana Lyons, picked up on this last week:
“Thus, we looked at all days since 1965 that saw at least 75% advancing issues on the NYSE, with a gain in the S&P 500 of less than 0.6%. As it turns out, there have been 15 such days, prior to yesterday. Again, 3 of those have occurred just since February.”
“Interestingly, all 16 days have taken place within secular bear markets (if you consider the market to still be in one, as we do). However, all but 1, or maybe 2, took place during cyclical bull markets. Whether or not that is instructive as to the market environment we are in, we won’t be able to say for awhile. But we did find it interesting.
What we can say is how the market fared following these days. Now, whether or not the historical results are relevant certainly may be up for debate. However, we did find the results interesting enough to present here.
Here is the S&P 500′s performance following the prior 15 occurrences.”
“Obviously, again, we’re dealing with a limited sample size – and with 1-day phenomenons. However, statistically significant or not, the trend has been for the S&P 500 to show consistent strength, from 2 days to 6 months out. 3 weeks (not shown) following these occurrences, the S&P 500 was higher 14 out of 14 times.
These are the kinds of results that we wondered if we would see following days like last Friday. Obviously, that was not the case. And considering the similarities between the 2 days, the conflicting results cause us to take these results with a grain of salt. However, at least this time, the results do heavily lean to the bullish side.”
Given the fundamental and earnings backdrop, the longer-term market dynamics are still heavily weighted against the bulls. As shown in the next chart, despite the recent surge higher in prices, the technical backdrop still remains bearishly biased.
With the exception of the number of stocks trading above their 200-dma, which still remains well below levels when prices were last at these levels, every other indicator is at levels and behaving as if we are in a more protracted bear market decline.
The question remains whether the markets will continue to “buy” the Federal Reserve’s “forward guidance” long enough for fundamentals to play catch up with the fantasy, or not. Historically speaking playing “leapfrog with a Unicorn” has tended to have painful outcomes.
Last week, I wrote a fairly extensive post on why I think oil prices are nearing their peak and made a case for trimming back on oil & energy related exposure. To wit:
“In a nutshell, the very easy near-term gains have likely already been seen. As I will explain below, the fundamental and technical backdrop suggests there will be plenty of opportunities for patient, long-term investors to pick up oil/energy exposure at cheaper levels in the months ahead.
With supply and demand imbalance likely to remain for years to come, it is very likely that we will once again return to a long period of volatile prices within a very confined range as seen during the 1980-1990’s. Therefore, for those wanting to invest in oil and energy related positions, the shorter-term price dynamics are going to be substantially more important.
If we take a look at the “Commitment Of Traders” report we see that exuberance over the recent surge in energy prices has pushed the number of oil contracts back to the second highest levels on record.”
“As with the past, these surges in contracts have typically denoted short-term peaks in oil prices. This time is likely going to be no different.”
A technical look at oil prices also suggests near-term profit taking in energy-related positions is likely a good idea. As shown, oil prices are not only trading at the top of a long-term downtrend channel but are also pushing 2-standard deviations above the mean.
With momentum and prices at extreme overbought conditions, a near-term reversion is very likely. I have noted each previous peak price in oil with vertical blue-dashed lines.
Of course, one of the main drivers of such a reversion would be a reversal of the recent weakness in the dollar. Like the advance in oil, the decline in the dollar has also been just as extreme. As shown below, denoted by yellow highlights, each previous downside extension of the current magnitude has resulted in a fairly sharp reversal.
With the Federal Reserve caught in their own “trap” of “strong employment and rising inflation” rhetoric, the markets may stay to worry about a rate hike in June. A perception of higher interest rates would likely reverse flows back into the dollar, and by default U.S. Treasuries, pushing the dollar higher and rates lower.
Speaking of rates, I suggested a couple of weeks ago as rates pushed 1.9% that it was time to once again add fixed income to portfolios. That call has been prescient and was even supported just recently by Jeffrey Gundlach at Doubleline. However, a recent article by Kessler Companies picked up on a key reason why I continue to suggest rates will fall to 1% in the future.
“But, the labor market is a subset of the economy, and while its indicators are much more accessible and frequent than measurements on the entire economy, the comprehensive GDP output gap merits being part of the discussion on the economy. Even with the Congressional Budget Office (CBO) revising potential GDP lower each year, the GDP output gap (chart) continues to suggest a disinflationary economy, let alone a far away date when the Federal Reserve needs to raise rates to restrict growth. This analysis suggests a completely different path for the Fed funds rate than the day-to-day hysterics over which and how many meetings the Fed will raise rates this year. This analysis is the one that has worked, not the ‘aspirational’ economics that most practice.”
“In an asset management context, US Treasury interest rates tend to trend lower when there is an output gap and trend higher when there is an output surplus. This simple, yet overlooked rule has helped to guide us to stay correctly long US Treasuries over the last several years while the Wall Street community came up with any reason why they were a losing asset class. We continue to think that US Treasury interest rates have significant appreciation ahead of them. As we have stated before, we think the 10yr US Treasury yield will fall to 1.00% or below.”
I couldn’t agree more which is why I continue to buy bonds every time rates approach 2%.
Okay, enough for now.
Next week should give us more information about what to do next.
“A mariner does not become skilled by always sailing on a calm sea.” – Herber J. Grant
I covered most of what we need to know for Monday morning in the commentary above. However, I do want to update the short-term analysis from last week.
Thursday and Friday saw the markets give up gains on the back of weaker than expected earnings and economic announcements. The action currently appears to primarily be profit taking after a long advance from the February lows. However, one should not be complacent the current action is simply that and nothing more.
All short-term indicators are overbought and on sell signals. The last time the same combination of signals existed was in November of last year. The resulting outcomes were not pleasant for most investors. There has not been a fundamental or economic development to suggest “this time is different.” In fact, in many ways, it is worse.
This more cautionary short-term analysis is supported by the breadth analysis as well. The number of stocks now trading above the 50 and 200-dma, along with bullish sentiment, is pushing more extreme levels. While this is bullish from the standpoint of participation, the extreme nature also suggests a near-term inflection point.
If we take a look at volume-by-price we also see a surge in volume at current levels which is suggestive of distribution by traders as markets reach primary inflection points.
These warning signs are worth paying attention to.
As I have repeatedly stated over the last couple of weeks the current market setup feels like a “trap.” I remain cautious and already have an “inverse market” position loaded in our trading system to move portfolios quickly back to market neutral if markets break support.
I suggest you prepare as well.
“If the weather forecast suggests it might rain, wouldn’t you carry an umbrella?”
The Sector Allocation Rotation Model (SARM) is an example of a basic well-diversified portfolio. The purpose of the model is to look “under the hood” of a portfolio to see what parts of the engine are driving returns versus detracting from it. From this analysis, we can then determine where to overweight sectors which are leading performance, reduce in areas lagging, and eliminate those areas that are dragging.
Over the last five weeks, RISK based sectors have continued their streak of improvements as money has flowed out of perceived areas of SAFETY.
Last week saw Energy and Discretionary join the ongoing leadership of Industrials, Materials, Small & Mid-Cap and International sectors. The Financial sector is trying to pay catch up currently.
Utilities, Bonds, Staples, REIT’s, Technology continue to weaken as “complacency” rises to more extreme levels. From a contrarian standpoint, this is a classic “set up” for a rotation from RISK back to SAFETY within the next few weeks.
HealthCare, while still very weak on a relative basis, showed a sharp improvement last week as money is chasing laggards in the rally.
Important Note: While small and mid-cap stocks have improved during the rally over the last several weeks, price action remains primarily concentrated in large-cap defensive sectors of the market. While the S&P 500 is approaching previous highs, the dividend sectors have gone virtually parabolic. Furthermore, small, mid-cap, international and emerging market stocks still remain in a negative downtrend and have made no progress over the last 16-months.
You can see the issue of the ongoing “yield chase” more clearly if we expand the time horizon.
Since the end of the “financial crisis,” many have assumed that taking on additional risk by small and mid-capitalization stocks would have yield the highest rate of return. However, while performance significantly outpaced the broader S&P 500 index, it was usurped by just buying the dividend-based stocks of the S&P 500.
The problem with this, as I have addressed many times in the past, is simply the extremely level of valuations being paid for these stocks will eventually turn out very badly. Much like the “Nifty Fifty” in the late 70’s, when the next recessionary decline comes there will be no “safe place” to hide. As Jeff Gundlach neatly summed up last week:
“The riskiest things are now stocks and other investments perceived to be safe. One of the most popular categories in US investing are low volatility stock funds. But there is no such thing! If you think that a stock like Johnson & Johnson can’t go down, you’re wrong. And if people own funds that invest in stocks which they think are immune from decline and they start to decline, all hell breaks loose.”
Lastly, despite the rolling rhetoric that “international and emerging markets” are the place to put money, these areas have been a continuing “anchor” on portfolio performance which is why I have kept these areas at a ZERO weight in the 401k plan manager model portfolio below.
As stated above, the SARM Model is an “equally weighted model” adjusted for risk. The current risk weighting remains at 50% this week.
We continue to watch for improvement in the relative performance of each sector of the model as compared to the S&P 500. The next table compares each position in the model relative to the benchmark over a 1, 4, 12, 24 and 52-week basis. Notice the relative improvement or weakness relative to index over time. For example, notice that sectors like Materials, Financials, Industrials, Technology Discretionary & Healthcare’s performance all weakened last week relative to the S&P 500. Normally, these performance changes signal a change that last several weeks.
The last column is a sector specific “buy/sell” signal which is simply when the short-term weekly moving average has crossed above or below the long-term weekly average. The number of sectors on “buy signals” has improved from just two a few weeks ago to 9 this past week. Sectors that are on buy signals tend to outperform in the near term.
The risk-adjusted equally weighted model remains from last week. No changes this week.
The portfolio model remains at 35% Cash, 35% Bonds, and 30% in Equities.
As always, this is just a guide, not a recommendation. It is completely OKAY if your current allocation to cash is different based on your personal risk tolerance, time frames, and goals.
For longer-term investors, we need to see an improvement in the fundamental and economic backdrop to support a resumption of the bullish trend. Currently, there is no evidence of that occurring.
There are 4-steps to allocation changes based on 25% reduction increments. As noted in the chart above a 100% allocation level is equal to 60% stocks. I never advocate being 100% out of the market as it is far too difficult to reverse course when the market changes from a negative to a positive trend. Emotions keep us from taking the correct action.
Two weeks ago I discussed the breakout of the market above technical downtrend resistance at 2080 and the initiation of a technical “buy signal.” With that, I increased the exposure to equities, reluctantly, in the 401k plan manager.
Over the past week, the market continues to struggle between resistance and support and is making little progress.
These is nothing to do now except to wait for either a breakout of the market to new all-time highs which would increase equity allocations further, or a breakdown below support reversing recent actions.
As we head into traditional summer weakness, the markets are at best a “coin flip” currently. While the “bulls” want you to believe the “only way is up” currently, the reality of a weak economic and fundamental backdrop suggests caution.
Since 401k plans have limits to switching funds to limit turnover, I continue to reiterate caution:
“With the technical damage to the market remaining over the intermediate and longer-term time frames, the reward of aggressively increasing allocations currently is still outweighed by the risk. So, any equity additions should be done with extreme caution and an “itchy trigger finger.”
For longer-term investors, the markets have made virtually no progress since January of 2015. Therefore, there is little evidence to suggest stepping away from a more cautionary allocation…for now.
If you need help after reading the alert; don’t hesitate to contact me.
The 401k plan allocation plan below follows the K.I.S.S. principal. By keeping the allocation extremely simplified it allows for better control of the allocation and a closer tracking to the benchmark objective over time. (If you want to make it more complicated you can, however, statistics show that simply adding more funds does not increase performance to any great degree.)
The list below shows sample 401k plan funds for each major category. In reality, the majority of funds all track their indices fairly closely. Therefore, if you don’t see your exact fund listed, look for a fund that is similar in nature.
Lance Roberts is a Chief Portfolio Strategist/Economist for Clarity Financial. He is also the host of “The Lance Roberts Show” and Chief Editor of the “Real Investment Advice” website and author of “Real Investment Daily” blog and “Real Investment Report“. Follow Lance on Facebook, Twitter and Linked-In